Thursday, December 17, 2009

On the Distribution of Gains from Government Action

Greg Mankiw has written a thoughtful post making the case for an investment tax credit. I was struck in particular by the following passage:

The cash-for-clunkers program is thought by many to have promoted, or at least accelerated, car purchases. An ITC would be similar, but it would apply to business investment rather than personal cars. Instead of targeting a very narrow, politically favored industry, it encourages investment broadly. It should have positive effects on aggregate demand in the short run and positive effects on aggregate supply in the medium and longer run.

The cash-for-clunkers program bothered me not only because it targeted a specific industry but also because it distributed gains among consumers on the basis of criteria that were very arbitrary. For instance, the requirement that eligible trade-in vehicles had to have a combined city/highway fuel economy of at most 18 miles per gallon excluded from participation those who had purchased fuel efficient vehicles in the past. This does not conform to any intuitive notion of fairness.

The biggest recent example of such distributional effects is of course the bailout of AIG counterparties by the Federal Reserve. Earlier this month I attended a speech by Bill Dudley at Columbia University in which he explicitly recognized the anger that such actions can fuel:

The actions taken by the Federal Reserve and others to stabilize the financial system had the effect of rescuing many of the same financial institutions that contributed to this crisis. Many of those financial institutions are now prospering, and many of their employees will be highly compensated. This situation is unfair on its face. But it is even more galling in an environment in which the unemployment rate is 10 percent and many people are struggling to make ends meet.

Later in the speech he returns to the issue:

... it is deeply offensive to Americans, including me, and runs counter to basic notions of justice and fairness, that some of the very same individuals and financial firms that precipitated this crisis have also benefited so directly from the response to the crisis. This has occurred at the same time that many Americans have lost their jobs and hard-earned savings. The public outrage this situation has produced is understandable. In the context of actions taken to support the financial system, the Federal Reserve and other government agencies have provided considerable support to banking organizations and other large systemically important financial institutions. The employees and executives of those institutions have benefitted from our intervention. In a perfect world we would be able to prevent those individuals and institutions from benefitting; we would have a better way to penalize those who acted recklessly. But once the crisis was underway, one goal took precedence: keeping the financial system from collapsing in order to protect the nation from an even deeper and more protracted downturn that would have been more damaging to everyone.

The issue came up again in the question and answer session (which is not transcribed in the published version of the speech).

I don't know whether there were options available at the time that would have secured the goal of maintaining financial stability without such a large redistribution of wealth in favor of those who stood to lose from an AIG bankruptcy. But it seems to me that such fairness concerns are not given enough early attention in the design of government policies.

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Update (12/18). I find Greg Mankiw's case for an investment tax credit quite convincing. He advocated the same policy a few days ago in a New York Times piece, but the substance of the argument there was lost amid the partisan jabs, on which Nate Silver pounced. I discussed the longstanding Mankiw-Silver feud here, concluding that "couching an economic argument in overtly moralistic or political terms can considerably diminish its impact." This is certainly a case in point.

3 comments:

Greg Mankiw never wants to admit the existence of externalities, asymmetric information, imperfect rationality, etc., because that would hurt the libertarian cause.

There's very good reason for targeting certain investments; certain investments, like in conservation, are grossly underprovided, provided way below the societal utility optimizing level, because of externalities, asymmetric information, etc.

If you can weight investment incentives more towards these market underprovided investments, like conservation, alternative energy, education, basic scientific and medical research, etc., etc., then you will create far more societal utility, then if the weights are shifted more broadly and evenly, meaning less in these things, and more in investment in a new luxury watch plant, a new luxury suit plant, a new bigger mansion or Mcmansion, and other goods of enormous positional/context/prestige externalities (by the way, for more on this please see Robert Frank's 2005 AER article,"Positional Externalities Cause Large and Preventable Welfare Losses", at: http://www.aeaweb.org/articles.php?doi=10.1257/000282805774670392

That said, "Cash for Clunkers" was an inefficient, poorly designed, and yes unfair way of investing in the environment. Environmental investments can have extremely high social returns in light of enormous externalities, asymmetric information, etc. They greatly lower risk (namely the risk, of planetary devastation; even if this were small, the risk of a house fire is small, but we still insure against it, and a planetary fire is a lot worse than a house fire); they can starve terrorist sponsoring states, and some of the worst authoritarian states in the world of money, thus giving a strong incentive for positive change; and, they can create a great deal of energy and scientific advance. But there were much better environmental investments for the money than cash for clunkers.

Why do economists assume that business owners are morons? Why would someone invest in a business when demand has collapsed? Yes, I know, if you are planning to burn your place down for cash, you might invest to increase its appraised value, but otherwise it doesn't make any business sense.

Now, if the government just started handing out gift cards or opened a retail window at the Federal Reserve, it might increase demand for goods and services and that might allow businesses to justify increased investment spending. Basing a recovery plan on the assumption that business owners are stupid just doesn't strike me as sound financial policy.